Margin of safety

This expression was a favourite of the father of value investing techniques, Benjamin Graham.

He suggested that the best way to ensure you don’t overpay for an investment is to buy when the market price is below a stock’s ‘intrinsic’ value. That value may be obtained by applying a number of different valuation techniques – for example, discounted cash flow.

The margin of safety itself is the gap between the price you pay and what you think a stock might be worth. So, for example, if you think a share is worth £2.50 and you only pay £2, you have a margin of safety of 50p (useful should you get your original £2.50 valuation wrong).

In theory, the bigger the safety margin, the better. However, the problem with setting it too wide is that you may eliminate some good stocks from your target population.